February 14, 2018
Britain’s Labour Party has now committed to re-nationalizing many of the utilities that were privatized to such fanfare under Lady Thatcher in the 1980s. Reluctantly, we should admit that in certain respects the Labour Party has a point. Monopolies owned by private equity groups, as have appeared in the water industry, offer no accountability to anybody. But there is a better alternative, bringing both accountability and a proper incentive structure, much used in capitalism’s earlier days: the customer-owned cooperative.
Nineteenth century capitalism was in many ways much purer than the modern variety. The state sector was small, and there was no expectation that the state would or could intervene, so that the business cycle was treated as an Act of God. Consequently, leverage was much more sparingly used, and regarded with appropriate fear as more likely to cause destruction than creation. Public stock markets were embryonic, so most companies were owned by the founder and his family, maybe with a few outside capitalists from among the local region’s merchants. Most important, with operations mostly smaller in scale and the modern idea of the large publicly-traded company not established, there was a greater willingness among company promoters to try alternative capital structures, notably partnerships, but also several forms of cooperatives.
Early examples of cooperatives
There were two difficulties in starting a 19th century cooperative: raising the capital and ensuring that the incentives involved produced a viable business, capable of competing with conventional capitalist firms. Capital raising was not too difficult, given the modest scale of most 19th Century operations, so the problem came down to ensuring that the incentives were properly aligned. There are three forms of cooperative that have been tried: employee owned cooperatives, producer owned cooperatives and consumer-owned cooperatives.
Employee-owned cooperatives seemed attractive in the early stages of industrialization and were much used where most of the workforce was highly skilled and hence could subscribe modestly for an ownership interest. The difficulty with them is that of ongoing management. Given the existence of the business cycle, from time to time decisions must be made that are in the interests of the organization, but contrary to the interests of some of the workforce. A management team elected by the workforce is then unable to manage, and the conflicts of interest between different groups of workers quickly get out of hand. Only a few such employee-owned cooperatives have survived to the present day; one example is Kiewit Companies, an Omaha-based construction conglomerate that appears to be owned mostly by its management (broadly defined) rather than by all employees.
Producer cooperatives, in appropriate industries, are easily constructed and suffer fewer conflicts of interest. These date back before industrialization; a mill could be owned by local farmers, for example. In commodity businesses, such as milk or flour, where the production adds value to an undifferentiated collection of inputs, no great marketing sophistication is needed, and the market is highly competitive, these work well. Indeed, the market imposes disciplines from the consumption side that keep costs down and quality up.
Consumer-owned co-operatives operate well when a product is a local monopoly, so that consumers cannot freely choose between competing producers. In the nineteenth century, retail and small business banking was local, so the business of home mortgage lending was in Britain carried out by “building societies” which were owned by their depositors. This was an admirably efficient system, swept away by Lady Thatcher’s misguided 1980s financial sector “reforms.”
Prime Minister Thatcher’s reforms
The fate of the building societies indicates the perverse incentives which a primitively market-oriented system can bring. Under Thatcher’s legislation, building societies could turn themselves into banks, raising capital from the stock market and then (naturally) paying the proceeds as windfalls to their depositors. This naturally led to a game whereby, as each building society went public, the depositors would take their winnings and put them in another building society, gambling on another bank conversion.
Amusingly, one of the bigger winners from this nonsense was my late mother, who disapproved strongly of bank conversions of mutual building societies, which she regarded as less prone to dangerous speculation than banks. Therefore, as each bank conversion happened, she transferred her money to another building society she thought safe from bank conversion — only to receive another substantial payout when that one also converted, requiring her to move her money again. Altogether, she suffered four of these conversions, receiving four substantial payouts, all on the same modest but rapidly becoming less modest pool of savings!
Britain’s privatizations in the 1980s
To return to Britain’s 1980s privatizations, incentives were always part of the problem, at least in industries that were natural regional monopolies. Pricing is determined only by the regulator, who over time gets captured by the industry. In Britain, unlike the United States, utility regulators set a fixed price for the product on an “inflation minus” basis rather than allowing a maximum rate of return. The initial broad base of shareholders attracted by privatization will sell out over time. These are by definition not very exciting investments.
In recent years, with the lengthy period of low interest rates and “funny money”, the utilities have become attractive to large hedge fund and private equity shareholders, who collude with management to reap returns by financial engineering and other short-term games, while neglecting investment, maintenance, and other long-term needs.
All but three of the ten British regional water companies are now owned by private equity investors, while the industry’s debt has sky-rocketed. As for tariffs, they have risen by over 40% in real terms, because the EU’s environmentalist regulators have imposed idiotic requirements on the industry, which it has been in nobody’s interests to oppose, since the regulator allows for the costs in the charges it permits.
Short term approach
Ownership by private equity, for a natural monopoly, brings huge conflicts of interest not present in ownership by a wide group of public shareholders. The owner has a relatively short time horizon and is not interested in preserving value for the long term – a very damaging approach in an industry where some of the infrastructure is a century old. The owner also wants to maximize leverage, and extract dividends from the utility as quickly as possible, to increase his nominal rate of return on equity. It is thus not surprising that even Scottish Water, still owned by government, has done a better job than utilities with such feckless ownership.
Public ownership not the answer
The Labour Party’s call for the utilities to be taken back into public ownership is not the answer. Since Labour appeals these days to the young, its voters doubtless do not remember the shambles of British nationalized industries in the 1970s, competing against each other for who could suck most money out of the Treasury and who could organize the most damaging wildcat strikes. The incentive structures of public ownership are hopeless; the company becomes a dead body feeding the leeches of its unions and the local politicians. Customers and cost controls come last. You can be sure that the service provided will be both overpriced and lousy. (Scottish Water is not a counterexample but a special case, in which political and nationalist objectives ruled; the socialists in charge of it were determined to prove it better run than its private counterparts down south.)
Ownership by users is the solution
Co-operative ownership by users is the ideal solution to these problems. Since the users own the utility, management will be focused on minimizing the long-term costs of its service, a thoroughly market-oriented incentive system. There will be no short-termism or management rip-offs, because the owners will not permit it.
Environmental diktats will be resisted or, if inevitable, implemented at the lowest possible cost to the users. Other innovations will be implemented efficiently if they generally reduce costs. Management salaries will be moderate, because there will be no incentive on the owners to increase them inordinately. Leverage will also be moderate; there will be no incentive to increase it; and the owners will want the company to survive any downturns. Finally, while there will still be a need for environmental regulation, there will in the long-term be no need for price regulation, since the owners will determine the prices charged by the company.
The challenge of raising capital
The only difficulty is how to raise the capital to put this system into effect. The simplest solution would be to apply a 10-year surcharge to utility bills which after that time would transfer ownership of the company (interim control being with a board of trustees appointed by the users).
With today’s low interest rates, and a steady stream of income available, funding this should not be too difficult. Alternatively, we could let the current overleveraged companies (most of them) go bust in the next downturn, and then transfer ownership for nothing. Either way the long-term effect would be to produce companies that were not quoted on a stock market, and whose ownership went with consumption of the product (water or electricity, for example) and where the incentives for economy, innovation and stewardship would be properly aligned.
Adam Smith invented capitalism, but he thought small private companies the ideal representatives of it. Large publicly quoted behemoths like the East India Company he regarded as hopelessly corrupt and inefficient. With user-owned cooperatives for natural monopolies, we would be putting his principles into action.
|Martin Hutchinson is a GPI Fellow. He was a merchant banker with more than 25 years’ experience before moving into financial journalism. Since October 2000 he has been writing “The Bear’s Lair,” a weekly financial and economic column. He earned his undergraduate degree in mathematics from Trinity College, Cambridge, and an MBA from Harvard Business School.
This article was originally published on the True Blue Will Never Stain http://www.tbwns.com
The views and opinions expressed in this issue brief are those of the authors and do not necessarily reflect the official policy of GPI.